J.P. Morgan Global Asset Allocation Note Discusses Cyprus Bailout and Market Outlook

Jan Loeys Global Asset Allocation (1-212) 834-5874 The J.P. Morgan View [email protected] 28 March 2013 Equities The global rally in equity markets slowed this week, but did not reverse, on continued concerns about the fallout from a poorly executed Cyprus solution. The Euro area underperformed again, for a second week in arow. As discussed last week, we view Cyprus as a local problem that we address by underweighting Euro area equities in a global portfolio. A potential negative feedback loop from markets to the economy poses a serious downside risk for Euro area growth over coming months prolonging the current run of negative economic surprises from the region. Japan is the region we like the most. In our mind the Japanese equity trade has further legs not only due to prospective BoJ balance sheet expansion but more importantly due to a reform agenda to be unveiled into the summer. EM equities are suffering from renewed policy tightening in major EM economies such as Brazil and China. Investors have bitter memories of previous property tightening measures in China. As within DM, we see a lot of divergences within EM and prefer to focus on under-owned markets with good domestic demand story such as Mexico and Malaysia. See “Consensus Asset Allocation”, Adrian Mowat and team, Mar 26th. Open overweights in Mexican and Malaysia equities vs MSCI EM. For long-term investors we just released our quarterly publication "Trade opportunities for long term investors" Mar 27. We monetize risk premia in Value stocks via a long in S&P500 Value vs S&P500 ETFs. It appears that a five year long underperformance of Value stocks has come to an end. We take profit on trades that monetize skew risk premia in S&P500 due to sharp contraction over the past quarter. We continue to monetize equity risk premia via buying high dividend yield equity ETFs against USTs. Our preference is to buy ETFs which track the S&P US Preferred stock due to its high yield, around 6%, and its high weight on Financials. Credit The news flow from the Cypriot bailout continued to push spreads wider and vol higher this week, with European Financials underperforming as creditor bail-in risks returned to the forefront. iTraxx senior and subordinated financials indices widened 20bp as investors sought to hedge via CDS rather than sell bonds. European credit continued to underperformed US credit. The fact that Cypriot banks debt is only 1.3% of total liabilities was a key factor in the decision to bail-in depositors. Yet events surrounding the banking sector restructuring also suggest that keeping senior unsecured bondholders immune from costly bail-outs is politically untenable. This removes the implicit ‘cover’ that senior bonds holders have enjoyed and has increased speculation that implementation of the bail-in proposals under the EU’s Resolution & Recovery Directive (RRD) will be brought forward to 2015 from the current 2018 time-frame. As such, our colleagues in European Credit have examined the implications of changing recovery rate expectations across the bank capital structure. Assuming that covered bonds remain outside the scope of the proposals, we expect senior bank bond spreads to widen relative to covered bonds and prefer being OW covered bonds vs senior bonds in the periphery, particularly in Spain where covered bonds have first claim over the entire mortgage book of the bank. From a relative value point of view, we also suggest owning subordinated bank bonds vs senior bank bonds in the core as, under the new RRD regime, there is a higher probability than before that J.P Morgan More details in ... US Credit Markets Outlook and Strategy, Eric Beinstein et al. High Yield Credit Markets Weekly, Peter Acciavatti et al. European Credit Outlook & Strategy, Steven Dulake et al. Emerging Markets Cross Product Strategy Weekly, Eric Beinstein et al. HOUSE_OVERSIGHT_030850